Factors

• Quantitative investing means investing based on quantifiable characteristics
• Stock characteristics that predict returns are sometimes called factors. Examples:
  • value (cheap relative to book, earnings, …)
  • momentum (high past return)
  • liquidity (high volume, low bid-ask spread, …)
  • volatility
  • quality (profitability, high cash flow to income, …)

Sorts on characteristics

• Sort into quintiles or deciles
• Equally weighted or value weighted return of each group
• Re-sort at the beginning of the next period
• French’s data library: monthly sorts and returns

Investing in multiple factors

• How best to combine factors?
• Could sort on factors separately and intersect sorts
  • Example: quintiles and 2 factors \(\Rightarrow\) 25 groups
  • Quintiles and 5 factors \(\Rightarrow\) 3,125 groups. Many will be empty.
• Could form portfolio for each factor and equally weight
• Could combine factors to predict returns and then sort on predictions

Industry examples

Factor investing at BlackRock

Factor investing at AQR

Market efficiency

• The Efficient Markets Hypothesis is that it is not possible to earn extra returns without taking on extra risks.
• Factor investing can be profitable even if markets are efficient.
  • The returns to factors may be risk premia.
  • Some investors may not be as averse to some risks as others are, so they should pick up the risk premia.